United States: Factors Affecting Economic Substance Determinations

Last Updated: June 5 2019
Article by Benjamin Alarie

Owing to the fact that many legal questions can be framed as binary classification problems, there are enormous possibilities for applying predictive algorithms to the law. Building on recent advances in machine learning, my colleagues and I at the University of Toronto have created a system that analyzes patterns in the case data for a range of tax law questions. As cases are inputted into the system to form a data set, the machine learning develops an algorithm that, after testing and calibration, can predict how the courts are likely to rule in a new scenario. Each prediction is also accompanied by a confidence level expressed as a percentage.

Our system also allows us to observe how changing the fact pattern of a case affects the probability of the outcome. In Part 2 of this series, we investigated how the presence of financial risk factors significantly alters our algorithm's confidence in determining whether financing is debt or equity. In Part 3, we explored how different behavioral control factors affect the likelihood of finding that a worker is an employee and not an independent contractor.

In this article, we'll see how machine learning handles a much more complex tax question: does a transaction undertaken by a taxpayer as part of its business, trade, or income-earning activity have economic substance?

The Economic Substance Doctrine and the Legal Test

The federal tax code states that in order for a transaction to be recognized for tax purposes, it must pass a two-pronged test (Section 7701(o)(1)):

(1) Economic effect: It must change "in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position."

(2) Substantial purpose: The taxpayer must have a "substantial purpose (apart from Federal income tax effects) for entering into such transaction."

If a transaction has no purpose or effect beyond generating tax savings for the parties involved, it lacks economic substance. The Internal Revenue Service will collect the taxes as though the transaction hadn't occurred and will impose a penalty of 20 percent of the disallowed benefit. This penalty may be increased to 40 percent in cases of blatant fraud (Sections 6662(b)(6), 6662(i)(1-2)).

Although the two-pronged test outlined in the statute provides general guidance, courts primarily use a multi-factor common law test when trying to determine whether the economic substance doctrine applies to a particular transaction. For our machine learning system, we selected the factors most commonly mentioned in the leading cases, as well as many of those listed in the IRS 2011 directive on the economic substance ("Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties"). When the system was calibrated and tested, we found that some factors had more influence on outcome than others. In the past, tax advisors had to rely on their intuition to determine how judges might assign weights to different factors and how these factors might be applied in future cases. By applying machine learning, we can augment professional intuition with concrete predictions.

In this piece, we will explore how changing different factors in existing cases affects the likely outcomes. We will explore the following three factors:

  1. The flexibility of the transaction,
  2. Expectation of pre-tax profits, and
  3. Unnecessary transaction costs.

(1) Flexibility of the Transaction: Negotiation and Choice

Let's begin by looking at questions that relate to the flexibility of the transaction:

  • Did the taxpayer negotiate a favorable change in price or obligations?
  • Were any of the entities in the transaction prevented from having a choice as to how to use the cash (or cash equivalents) they received?

In determining whether a transaction has a substantial and legitimate business purpose, courts often look for evidence that the taxpayer attempted to negotiate a better deal. Sham transactions—transactions that have no purpose other than reaping tax benefits—tend to depend on fixed, predetermined prices in order to produce the anticipated tax savings. Negotiating a more favorable price suggests that the transaction is flexible and that the taxpayer is motivated by profit, both of which point toward economic substance. Sham transactions also frequently involve carefully planned circulation of money between entities. This means that some of the parties involved have no say over the use of the cash (or cash equivalents) that they receive.

Intuitively, negotiation and choice would seem to be very important factors. But how much of an impact do they have? Under what circumstances are these factors decisive?

In 85 Gorgonio Wind Generating Co. v. Commissioner, the taxpayer partnership purchased two wind turbines and made a deal to have the turbines installed and operated in a wind park owned by another company. The deal resulted in a loss, and the taxpayer claimed substantial depreciation, investment, and energy tax credits. The IRS challenged the claim, but the Tax Court ruled that the transaction had economic substance. The court noted in particular that the partnership had negotiated a backup agreement with the wind park owner to receive revenue regardless of the profitability of the wind turbines. There was also no indication that either party lacked control over the use of the money that they received in the transaction.

Inputting the facts of this case into our system yields a prediction that aligns strongly with the court's finding of economic substance. What would have happened, however, if the taxpayer hadn't negotiated a more favorable deal with the owners of the wind park?

We can re-compute the scenario using the same facts as 85 Gorgonio, but with no negotiation. Here, our system still generates a prediction of "economic substance." The probabilistic likelihood of this answer, however, falls by about 8 percent. Even if one of the parties hadn't been able to choose what to do with the money it received, the probabilistic likelihood would only drop by another 8 percent. Taken together, of course, that's a significant decrease. But our machine learning algorithm shows us quite clearly that neither of these two factors has sufficient weight to change the predicted outcome in this particular case. The other facts still weigh in favor of a finding of economic substance.

(2) Economic Effects: Expectation of Pre-Tax Profits

The next factor we'll examine relates to the economic effects of the transaction: does the taxpayer expect pre-tax profit from the overall transaction?

The tax code includes a special rule that applies when a taxpayer attempts to defend the legitimacy of a transaction by arguing the existence of profit potential. Profit potential should only be taken into account, the legislation reads, "if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected" (Section 7701(o)(2)(A)). In other words, the presence of profit alone doesn't prove economic substance. In order to be respected by the IRS, the expected profits from the transaction must be "substantial" compared to the tax benefits.

In Johnson v. Commissioner, the taxpayer entered into a scheme that involved leasing stamp masters, the photographic color separations used to produce various kinds of stamps. The taxpayer signed a seven-year lease to purchase the masters, which were alleged to be worth over $280,000. In the first two years of the lease, the stamps produced by the taxpayer's masters yielded just $14 in revenue. When the IRS challenged the taxpayer's attempt to claim nearly $50,000 in losses and investment tax credits, the taxpayer claimed that he entered into the transaction with the intent to profit from the sale of the stamps. Even if the transaction itself was a sham, he argued, the profit objective alone entitled him to the deductions. "This argument," the Tax Court judge wrote, "is without merit."

Our system agrees: the facts of this case point to an outcome of "no economic substance" with 92 percent confidence.

But let's suppose that there really was potential for profit from the stamp masters. Although profits would create a meaningful change in the taxpayer's economic position, as required by the tax code, our system still predicts an outcome of "no economic substance." The probabilistic likelihood of this outcome drops to 77 percent, but there are still enough factors flagging the transaction as a sham to keep the likely outcome as "no economic substance."

All tax advisors know that profit is an important factor in economic substance cases. It's no surprise that judges balance evidence of profit potential with other factors. The value that machine learning adds is much more interesting and useful: it allows us to observe the magnitude of the impact of profit potential in a given fact scenario.

(3) Unnecessary Transaction Costs

Our final economic substance factor is also the most significant: could the taxpayer have fulfilled the transaction's stated business purpose for a lower amount of transactional costs than what the taxpayer actually paid?

Taxpayers motivated by profit will normally try to minimize transaction costs. As a result, the IRS is more likely to challenge a transaction that features unusually high legal, accounting, or banking fees, unnecessary sales or brokerage commissions, or additional taxes. Excessive fees may indicate that the transaction is one of the many prepackaged schemes marketed to wealthy individuals and corporations as a means of generating tax benefits. These schemes, many of which are now illegal, go by a variety of colorful acronyms such as CARDS, STARS, SILO, BOSS, and Son of BOSS, but they all have the same basic purpose: generating losses and/or qualifying for tax credits.

After digesting the facts of hundreds of cases, our system found a strong correlation between unnecessary transaction costs and outcome. For example, if we look at 50 economic substance decisions going back to 2013, the presence of excessive transaction costs moved our algorithm's confidence level an average of 12 percent in the direction of "no economic substance." Depending on the details of the case, the actual effect ranged from 5 percent to as high as 20 percent. In some borderline cases, altering the facts to include or exclude unnecessary fees was enough to change the likely result.

One important takeaway here is that the impact of this factor depends on the other facts of a scenario. Machine learning—like human judgment—weighs the dynamic relationships between all the facts of a given situation. But machine learning algorithms can quantify these relationships more precisely than human judgment. In doing so, the vague standards that often result in even more vague advice can be defined with greater precision. Ultimately, the use of machine learning algorithms may lead to standards, such as the economic substance multi-factor test, evolving into a series of rules for any given situation.

Looking Ahead

As we've seen from this overview of key economic substance factors, machine learning provides us with a new level of insight into the law. While human lawyers and judges overvalue some factors and undervalue others, machine learning can weigh each factor in relation to how the courts have weighed the facts in hundreds of previous decisions. Not only does machine learning transform our understanding of judicial decision-making, it allows us to predict the outcomes of future cases with unprecedented accuracy.

In the fifth and final article in this series, we'll explore the application of machine learning to the question of whether proceeds from real estate transactions should be taxed as capital gains or ordinary income.

Benjamin Alarie holds the Osler Chair in Business Law at the University of Toronto Faculty of Law and is the CEO of Blue J Legal.

This article was originally published on the Bloomberg BNA website on December 27, 2018.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

COPYRIGHT ® 2018 BY THE BUREAU OF NATIONAL AFFAIRS, INC.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Events from this Firm
10 Jun 2019, Webinar, New York, United States

Taxpayers may sometimes find themselves in the crosshairs of the US Internal Revenue Service even where a transaction technically complies with the Internal Revenue Code but serves no real purpose apart from its tax effects.

10 Jun 2019, Webinar, Toronto, Canada

As a result of the US Tax Cuts and Jobs Act 2017, tax-exempt organizations are no longer able to aggregate gross income from multiple unrelated trades or businesses for the purposes of calculating their unrelated business taxable income.

26 Jun 2019, Webinar, New York, United States

As courts and federal agencies grapple with worker classification in an evolving economy, knowing how a worker is classified for tax and employment purposes is crucial for businesses of any size and the professionals advising them.

It’s not just Uber at issue: many businesses often rely on the work of independent contractors to some degree. Developments in the classification of gig workers are shifting consensus toward findings of independent contractor.

Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions